Can You Predict Risk and Return?

15 March 2016  |  Simon Miller
Can You Predict Risk and Return?
Most investors realise that return and risk are two sides of the same coin, one cannot exist without the other, even though the fund management industry would have you believe otherwise.

Most investors realise that return and risk are two sides of the same coin, one cannot exist without the other, even though the fund management industry would have you believe otherwise. Glance across the website or promotional material of most investment management firms and you’re bound to see a pompous display of stellar returns with little mention of the risk involved.

The industry’s fixation on advertising historical returns leaves no room to talk about risk, it’s as if the word is a taboo. But the problem with talking about historical returns is that they have no predictive value for the future. Interestingly, the regulators seem to agree, why else would they force all investment firms to add past performance disclaimers to their ads?

Let’s consider this. Investors are rewarded for taking risks and they receive a risk premium when they invest. A high-risk investment, in the long run, delivers superior returns in comparison to a low risk investment. If it didn’t, why would anyone ever take more risk?

Riskier Asset Classes Return on Average Higher Returns

Average annual return of asset classes (in %, 1998-2015)

Average annual return of asset classes (in %, 1998-2015)
Past performance or future projections are not indicative of future performance.

The next question we then need to ask is which investment gives us the best return for a risk level we are comfortable with? When evaluating the risk-return relationship, predicting the future is no easy task. Future returns like any complex problem have far too many variables involved. Quantitative, historical, even psychic models have all been used to try to predict future returns.

What is surprising is that most firms continue to employ a strategy based on predicting the future movement of asset prices and outperforming the market, which has thoroughly undermined the industry’s ability to successfully deliver returns.

What can’t we predict?

Nobel Prize-winning economist, Paul Samuelson believed that investment returns could not be predicted based on past performance, as they do not correlate in any relevant or identifiable way. In 1965, he demonstrated in his paper: Proof That Properly Anticipated Prices Fluctuate Randomly, that past returns had no impact on future returns; leading him to conclude that market prices are Martingales, a technical term for a scenario in which knowledge of past events cannot be used to predict the future.

We don’t have the ability to predict returns but what can be done is predict risk

He argued that a method for predicting returns could not exist as, ‘in a competitive market there is a buyer for every seller. If one could be sure a price would rise, it would have already risen’. The fact that 85 percent of fund managers fail to outperform the stock market after costs each year only corroborates his claim1.

Although, historical price developments are not an indicator for future performance, long-term historical data does add nuance and value when extrapolating returns for asset classes over longer time periods but even with this information, we cannot tell which direction an individual stock will move in over the next few days.
However, whilst we don’t have the ability to predict returns, we can predict risk to a much higher degree.

What can we predict?

Risk itself just means the chance of a negative outcome and is measured by the likelihood and magnitude of loss. It is possible to predict risk and the more data we have, the more accurately we can predict it.

It’s like insurance companies, they cannot tell you if you’re going to suffer from a certain disease but they can predict its likelihood and the potential costs involved. The same approach can be extended to financial markets, you cannot predict when you will lose money but you can predict the probability you’ll lose money and the magnitude of such losses.

Risk can be measured in various ways and one of the most common measures is volatility, which expresses the magnitude and frequency of up-and-down movements of the market. The higher the volatility of an investment, the higher the risk and the lower the volatility of an investment the lower the risk. There are other measures of risk too, arguably more relevant to an investor such as Value-at-Risk (VaR), but for simplicity let’s focus on volatility here.

Scientist-mathematician Benoit Mandelbrot first observed that “large changes tend to be followed by large changes, of either sign and small changes tend to be followed by small changes” when it comes to markets and called this volatility clustering. This intuition implies that if the market was very volatile today, there is a greater than a coin toss chance that it will be very volatile again tomorrow. Put simply, it enables us to predict risk.
But remember, volatility only bites on the downside, as the upside is always a welcome gain. So when predicting risk we’re particularly interested in predicting downside risk.

The use of volatility clusters to forecast risk was discovered by Nobel prize winning economist Robert Engle and this insight is particularly useful to investors as risk and the potential for return also have a positive correlation. Typically, we see that if there is an increase in volatility, there is an increased potential for return, however this is only true to a certain point.

Periods of Excessive Volatility Typically go Hand in Hand With Negative Average Annual Returns

Dax Stock Index Average Annualised Return for Different Volatilities (in % 1960-2015)

Dax Stock Index Average Annualised Return for Different Volatilities (in % 1960-2015)
Past performance or future projections are not indicative of future performance.

In periods of exceptional volatility the risk-return relationship becomes inverted, and increased volatility does not deliver better returns. The dotcom bubble or the 2008 financial crisis are examples of such circumstances. Therefore, if you can predict these excessive risk periods, you have a chance to reduce your exposure to relevant asset classes and thereby avoid the poor performance which is associated with that period of higher risk.

Since risk and return are so closely related, at least under normal circumstances, it is prudent to compare two or more potential investments not by comparing their absolute return over a given time period, but by factoring in their risk level as a way to “normalise” the data and to get a relative performance perspective.

At Scalable Capital, we understand the critical relationship between an individual’s risk tolerance level and expected return. Understanding that investments come with risk is of little consequence unless you’re aware of your own individual attitude to risk, which is why we have based our proprietary risk management model on this structure.

We gain an understanding of your investment objectives, financial situation, knowledge and experience using a questionnaire and also take into account if the risks associated with each particular investment strategy match the risk you are willing, and able to take.

Using the personal data collected, we suggest one of 23 risk categories to a new customer. They can then fine-tune their risk category to exactly match their personal preference. Each risk category reflects the percentage loss in portfolio value that should not be exceeded in a one-year period with a likelihood of 95%, so on average in 19 out of 20 years.

This corresponds to a Value-at-Risk (VaR) with a 95% confidence level. We then monitor each portfolio’s risk level. Once our risk projection predicts the likelihood of a higher loss for a portfolio than the customer had defined, we increase the share of lower-risk asset classes in the portfolio in order to prevent unexpectedly high losses – and vice versa.

Dynamic Risk Management Model

If a breach of the risk limit is predicted, an adjustment is made to the portfolio weights

Overall your investment risk is regularly monitored, adjusted and does not just fluctuate in unison with the risks of the financial markets. The effect of this is to increase the likelihood of avoiding excessive risk and low returns.

Learn more about our ability to predict risk here.

Benjamin Graham, the famous investor and mentor of Warren Buffett said: ‘The essence of investing is the management of risk, not the management of return,’ and for successful investment management, it is pivotal this is recognised.

1 https://www.institutional.vanguard.co.uk/documents/case-for-index-fund-investing-uk.pdf

Risk Warning – With investment comes risk. The value of your investment can go down as well as up and you may get back less than you invest. Past performance or future projections are not indicative of future performance. We do not provide any investment, legal and/or tax advice. If this website contains information regarding capital markets, financial instruments and/or other topics relevant for investments of assets, the exclusive purpose of this information is to give general guidance on investment management services provided by members of our group. Please note our Risk Warning and the Website Terms.

 

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Simon Miller
UK CEO & UK CO-FOUNDER
Formerly a derivatives trader at Barclays Capital, Simon merges capital markets knowledge and business development skills with an academic background in Economics, Business and Mathematics.